Sunday, 17 February 2019

On a number of occasions here in Financial Regulation Matters we have discussed the credit rating
and audit industries. They have taken up a number of posts on account of their
negative and impactful behaviour, and in most of the posts we attempt to conclude
as to why they a. act in such a manner, b. are allowed to continue acting in
such a manner, and c. what may be done to alter that behaviour. Often, we
conclude by discussing the oligopolistic
features of their industry and implying that those dynamics are the fundamental
answer to all three aspects. However, the word oligopoly is sometimes defined
within the posts, but often it is not elaborated what the concept is and why it
is so impactful within these financial industries that are so crucial. In this
post we will dissect the concept of an oligopoly and examine why the two
identified industries are absolutely defined
by the concept.

The term oligopoly roughly derives from
the Greek wordsoligoi – meaning ‘few’
– and polein – meaning ‘to sell’ – with
the essential meaning of a few sellers being helpful. The term itself will
usually link one’s thinking to the concept of a Monopoly, meaning one seller,
and then a duopoly, meaning two sellers. The actual coining of the term stems
from the esteemed French mathematician Augustin Cournot who, in 1838, wrote Researches into the Mathematical Principles
of the Theory of Wealth. Friedman discusses how within this noted work,
Cournot introduced the theory of an oligopoly, but that ‘its
most astounding characteristic is its complete originality. Usually, such a
field of study develops through a series of stages, one shading into another,
at the hands of a succession of writers’. Friedman notes that, before
Cournot, there was no development of the theory. Before this development,
Friedman notes how the word ‘monopoly’ was used to describe all variants –
monopoly, oligopoly, and duopoly. The theory established by Cournot is
particularly technical and is described in detail here.
In order to simplify the concept, it is useful to think of the issue of having
a number of sellers within a specific marketplace as being constrained by two ‘end-points’:
collusion and an oligopoly. For example, in the marketplace the sellers could
collude with each other to determine the price of the product(s) sold within
that marketplace. However, as collusion is illegal in most economies, the
result would be not only the potential of criminal investigation, but also the
lack of a bind between the sellers based upon the illegal status of the agreement.
So, in opposition to this, it has been noted that in an oligopoly the sellers
will adjust their output ‘independently
of the other firm’s output to maximise its profit’. Admittedly, the
economic theory does become complicated and operates firmly within the comfort
zone of Economists, but the essential sentiment is that the companies within
the oligopoly have the ability, on account of them all essentially selling the
same product, to analyse the strategy
of their counterparts and develop their own strategies accordingly – the element
binding them all together is the aim to maximise their profits. In that same
sense then, undercutting your oligopolistic partner would not serve to maximise
your profits, which preserves the status of the oligopoly itself.

However, there are other factors which affect an oligopoly
and deviating from Economics for a moment will help us illustrate this better.
If we use the financial services sector as a lens, then the audit and credit
rating industry provide perfect examples of both oligopolies, but also what
variables preserve that oligopolistic structure. In the excellent Corporate
Power, Oligopolies, and the Crisis of the State, Professor Luis
Suarez-Villa discusses what he labels ‘corporatocracy’ – ‘the overwhelming
power of corporate interests over governance and society’ – and that
oligopolies are absolutely crucial to the development of that power dynamic. In
relation to this dynamic, he states that ‘corporatocracy is as important to
oligopolies as water is to marine life – one cannot exist without the other’.
Suarez-Villa is not hesitant when it comes to affirming his views on the power
dynamic, and his view on the role of the oligopolistic vehicle is never as
clear as when he states that in those ‘markets that neoliberal ideologues have fervently
advocated for are mostly dominated by corporate oligopolies. Oligopolies that wield
immense power over most everything we do, in most sectors of the economy, and
that influence most every aspect of public governance’. So, for Suarez-Villa,
the influence of corporate oligopolies is abundantly clear if one cares to
look. At first glance, the viewpoint expressed above seems almost
conspiratorial, belonging within the realm of ‘conspiracy theory’. However, not
only is the Professor’s work meticulously researched – as we would expect – but
there are examples all around us.
Just two examples are the credit rating and audit industries.

Starting with the credit rating industry, this author discusses
in meticulous detail the development of the industry from its
non-commercial beginnings (with the Baring Brothers banking empire’s move into the
antebellum [pre-war] United States), to the commercialised beginnings with the
social reformers Lewis Tappan in the 1840s (via a failed venture in the 1830s).
After enjoying a monopolistic situation in the first few years, Tappan would be
joined in the marketplace by John Bradstreet, and his entrance was predicated
upon methodological advances that served to quantify the process of credit
rating. Henry Poor would develop his company based upon extensive knowledge and research of the rail roads, and John Moody
would develop his company on the basis of a clearly defined Manual in the early 1900s. Once the
split between credit reporting and credit rating – the former being
concerned with a qualitative analysis of debt, and the latter concerned with
presenting alphanumerical ratings – occurred at the turn of the turn of the 20th
century, very little has changed. The merging of Standard Statistics with Poor’s
company in the early 1940s gave birth to the modern-day Standard & Poor’s,
and alongside Moody’s the duopoly was developed and has maintained ever since. The
development of Fitch Ratings from 1914 has done little to dent the dominance of
the Big Two, but is substantial enough to declare the modern industry as
representing a pure oligopoly – the Big
Three control more than 90% of the market between them. There are two elements
which allow the oligopoly to continue irrespective of external pressure, and
those elements are also witnessed in the auditing industry. The first is that
all of the rating agencies, essentially, sell the same product. There are
slight differences in the underlying methodologies behind the credit ratings,
but essentially it is exactly the same offering (particularly with the Big
Two). This serves limit competition because there is little use on 15 companies
all doing the same thing. This leads us to the second and by far the most
important issue, and that is the purpose and usage of the products being sold.
It is often found within corporate oligopolies that it is the consumer that
maintains the oligopoly, not regulation or legislation which is often
criticised as protecting the oligopoly. For instance, the modern economy is
defined by dispersed investors – say,
institutional investors like a pension provider – and those investors have a
number of competing pressures affecting them at any one time. Their managers
must take certain investment decisions, but their principals, the pension holder, will want to a. know what the
manager is doing and how they are performing, and b. constrain that management
if there is a need to. Now, the pension holder would find it massively
inefficient to review every financial decision the management take in detail,
and if that were the process it would be so laden with inefficiency it would
make the act of investing counter-productive in terms of profiteering. So, it
is in this gap – what is called ‘informational asymmetry’ – that the credit
rating agencies exist. They provide easy-to-understand and easy-to-assimilate
information on what are often extraordinarily complex financial actions. That asymmetry
is resolved, theoretically, by the rating agencies. If we return to the dynamic
mentioned above then, the consumer of the ratings would therefore be
disadvantaged if there were 10 leading rating agencies, because which one is
best to follow? Which one is most accurate? Which one can be trusted? With Moody’s and S&P demonstrating reputations
spanning more than a century, that reputation breeds trust. Yet, this is all
very theoretical and we shall see shortly why.

The audit industry is remarkably similar to the credit
rating industry. It is led by the ‘Big Four’ – PricewaterhouseCoopers,
Deloitte, Ernst & Young, and KPMG, and their histories go back longer
still. However, whilst the rating agencies’ function is central to the capital
markets and their development, auditors are arguably central to the economy as
a whole. In any interaction within the business sphere, trust is a central
component. Even with reputation, how can one really trust in another? What
happens if a traditionally trustworthy entity suddenly changes course? It is
within this truly-foundational asymmetry that auditors sit. The modern day
auditors fulfil a number of crucial roles within the marketplace, but acting as
the primary ‘check-and-balance’ within business and within a host of
transactions makes the existence of auditors crucial. So, even more so with
auditors, what would the effect be of increased competition? The auditors are
constantly facing ‘competition
probes’ and suggestions that competition
needs to be increased, but the reality is ‘increased
competition in audit markets impact audit quality negatively’ – calling for
increased competition within a perfect oligopoly displays a fundamental
misunderstanding of an oligopoly. The consumers of audit ‘products’ would be
fundamentally disadvantaged by an increase in competition, as the ability to
trust in the auditor’s decisions would be compromised, thus making the whole
process inefficient. We can see here that these two examples demonstrate the
core constituents of oligopolistic characteristics – a market that competes on
price but one which contains actors which can easily match their strategies to
their competition’s based upon the selling of the same product, and a consumer
base that would be actively disadvantaged by an increase in competition, thus
preserving the oligopoly and preserving the cycle.

Any regular reader of the blog will know that this story
cannot finish here. We have covered almost every negative action taken by the
credit rating agencies since before the Financial Crisis, and we are kept abreast
of negative developments within the audit industry. We will not go back over
them here, but what can be easily seen just by keeping up to date with the
business media is that these two industries consistently
transgress (misbehave), even despite record penalties and massive regulatory
action. We see the rating agencies receive over $2 billion in fines between
Moody’s and S&P, a record figure, and then continue to transgress via
methodological failings that favour the issuer over the investor. As for
auditors, their misbehaving has shown absolutely no restraint, with almost
every member of the Big Four taking up column inches in the business media on
an almost daily basis (this is no exaggeration). A statement from Suarez-Villa
seems absolutely relevant here and can, in terms of providing a juxtaposition,
give us the answer why these industries continue to misbehave. Very early in
the book Suarez-Villa declares that ‘the relations of power that oligopolies
represent are largely ignored by the public today – lost in an avalanche of
reports that are largely pro-corporate, and that view corporate interests as
beneficial to most everyone’. So, according to this viewpoint, the public are
not aware of the power of the oligopoly. However, and much more importantly,
the oligopolists are aware of their position and subsequent power, and that is
the primary reason why we see repeated transgressive behaviour. It does, admittedly,
sound like a severe over-simplification, but the reality is that these
industries transgress merely because they can, and it is extraordinarily
lucrative to do so. Yes there are a number of criminological, philosophical,
biological, anthropological, and many other perspectives that we could apply to
why actors within these industries transgress, but what is for sure is that the
oligopolistic vehicle is what fundamentally allows them to do so.

Credit rating agencies are beginning to fall away from
public view a decade on since the Financial Crisis, mainly because their
transgressions are now ‘limited’ in their scope. For auditors, the situation is
very much different and they beginning to experience scrutiny like they did at
the turn of the 21st century with their conduct surrounding Enron. This
is leading auditors
to defend their oligopolistic position, with some putting in measures like
the clear separation of auditing and consulting service provision, and some
even claiming that the perceptive role of auditors is wrong and should be
altered. Yet, the reality is, there is no cure. There is an abundance of reform
proposals, and an abundance of commentary that supplements criticism with calls
for disbandment of the industries etc. However, this does not take into account
the reality of the oligopoly and it
is suggested here that any reform proposal that does not take that fully into account is bound to fail.
Criticism and critical reform proposals are to be encouraged, but it is vital
they are directed to the most realistic and therefore potentially most
efficient route to altering the transgressive nature of these industries – and that
route is by fundamentally considering the dynamics of oligopolies and then taking
the appropriate action.

Saturday, 2 February 2019

We have only looked
fleetingly at the story of Grant Thornton – The British-founded ‘professional
services’ company that is now regarded as one of the largest firms outside of
the traditional ‘Big Four’ audit firms – and its connection to Patisserie
Valarie. As the chain sits currently in administration and is ‘set to
be sold off piecemeal’, the role of Grant Thornton in auditing the chain
just before it collapsed has brought the auditor firmly into the spotlight.
Grant Thornton’s CEO is currently facing questions from MPs and, as part of his
response, he has told the House of Commons Committee that there was an ‘expectation
gap’ between what is expected of audit firms and what they do in practice. In
this post, we will review the story and analyse the developments, but focus
more on this concept of an ‘expectation gap’ existing in relation to the
auditing industry, which is particularly centralised within the financialised
society we live in.

The same article discusses how the audit industry, or at
least three of its biggest players (PwC, EY, and KPMG) would be ceasing
providing ‘consulting services’ to FTSE 350 audit clients by the
end of 2020. We have discussed this issue of ‘consulting services’ before,
primarily in relation to the conflict-of-interest issue that similarly occurs
within the credit rating industry when they provide ‘ancillary services’ for
those who they rate (the sole focus of the author’s first
book), but it is worth asking whether this is enough to rebuild the public’s
trust in this particular sector. Though there are clear historical cases of
auditors’ failures, including Enron and WorldCom, the auditors will be quick to
label these as ‘legacy issues’. However, if we focus more recently, we can see
that the auditors, and this spread between them and not just one particular
auditor, have consistently failed in their remit. Recently there has been a number
of scandals involving auditing failures, including: Patisserie Valerie;
Carillion; Conviviality; Rolls-Royce; BT; Mitie Group; BHS; Sports Direct; Ted
Baker; and Quindell. It is bordering on the remarkable that there is even a
question over the competency of these massive global firms; it is clear there
is something inherently wrong with the operations of these companies.

It is difficult to pinpoint where that problem lies however,
and that is assuming there is just one problem. Reviews of the associated
regulators have found that, in the case of the FRC, the regulator is ‘built
on weak foundations’, whilst it has been suggested by a number of observers
(chief amongst which is Professor Prem Sikka) that the auditing and consulting
arms of the auditors should be fundamentally split. In this author’s first book
cited above, there was a discussion on the auditing industry and that fed into
the calls to enforce the splitting of
these two arms within the credit rating industry, and make the splitting of the
arms irreversible. This suggestion
was based on the fact that, after the Enron and WorldCom scandals, the US-led
Sarbanes Oxley-era provided an environment where, essentially, the largest
auditing firms were pushed to divest from their consultancy arms. Although the
credit rating agencies (S&P in particular) went on to acquire a number of
components from this divestment, there was a fundamental issue in that the
Sarbanes Oxley-led divestment was done with the sentiment of encouragement,
rather than enforcement. The auditors did divest, but they did so on their
terms, with short periods being declared as to when they would not conduct
consultancy services from that point. Inevitably, in the run-up to the Crisis,
the auditors had rebuilt these consultancy arms that were directly identified as
being crucial to the Enron-era degeneration in standards, and since the Crisis
these consultancy arms have continued to grow. Now, with PwC, EY, and KPMG telling regulators that they will
divest, it appears the same thing will happen again; the auditors will respond
to public demand, but wait for the news cycles to oscillate away from the
industry and then rebuild. This tremendously cyclical arrangement is continuing
unabated, and many seem happy for this to be the case because it resolves an issue
now, and not fundamentally.

Another aspect is that the so-called ‘Big Four’ are an oligopoly,
and that is a vital understanding. The theory of the marketplace is that the
firms will compete on quality and price, and what will result is an efficient
sector that is affordable to the customer. However, in an oligopolistic
marketplace, those elements do not exist. When one firm takes a certain action,
the other members of the oligopoly will usually, and it is argued here that they must, take the very same
action – this is represented clearly with the firms stating that they will stop
providing consultancy services to FTSE 350 companies who they provide audit
services to as well (KPMG started this sentiment and the others followed). So,
if we accept this oligopoly-based theory is the truth, and it surely is, then
the options available to regulators are extraordinarily limited. They cannot
seek to encourage competition to disturb the hegemony within the oligopoly
because an oligopoly is defined by a lack of competition. Also, increasing
competition has the potential of perceptively
reducing quality within the sector, and even though it may sound paradoxical,
many customers would not want a potential reduction in quality even though the
sector is clearly fraught with inefficiency – customers know what they are
getting with the Big Four and, crucially, the validation received from the Big
Four still carries value with external elements, such as investors. Whilst the
value exists, the oligopoly will also exist, as is the theory of oligopolies (a
great book on Oligopolies can be found here
by Luis Suarez-Villa). With that in mind, the current situation is unlikely to
change. What will probably happen, and it is strongly suggested here that the
following is almost guaranteed to happen, is that the auditors will respond to
external pressure in a manner that placates that external pressure, after which
they will perform, for a while, in a manner that removes scrutiny from the
sector. Once that scrutiny passes and moves onto another sector, the audit
sector will re-develop the very same practices and the cycle will simply continue.
If one is uncertain about the direction of a certain sector, it is usually wise
to look backwards. The cyclicity within the marketplace is abundantly clear to
see, if one cares to examine it within that set of parameters. If one is
looking for a political victory, in the here and now, then it will be easy to
overlook such a trend. It will be worth noting the current stage where it has
been identified that the mix of auditing and consulting arms are one of the
fundamental keys to auditor failings, and see how long the industry-led
impediments on that combination actually last; it will likely be not very long
at all.

Contributions are welcome to this blog. If you would like to contribute regarding any area of financial regulation, then please feel free to email me and submit your blog entry. The content should be concerned with financial regulation, and why it matters, but this is broadly defined. The blog is open to all who are professionally concerned with financial regulation, which may range from an Undergraduate Student interested in writing on the subject, to Professors and industry participants.